Markets use prices as signals to allocate resources to their highest-valued uses. Consumers pay according to their value for goods and services and accordingly the producers devote more resources to the production of such goods and services that are valued more by the costumers.
This allocation principle applies both to product markets for items such as cars, houses and to resource markets for items such as labor, land, and equipment. Households play an important role in an economy as they demand goods and services and supply resources. Businesses also have dual roles as they supply goods and services and demands for resources. The interaction of demand and supply in the product and resource market generates prices that serve to allocate items to their highest values.
The resources are scarce relative to the demands of humans. Economies are thus concerned with the allocation of resources. The market price mechanism answers the questions of what and how much to produce, for whom to produce, and how to produce?
What and how much to produce?
Human wants are unlimited and resources are limited thus economy must make choices on the types of goods and services that it wants to make available to the country. It should be determined jointly by producers and consumers through the signaling role of prices and their self-interest. Price shows how much consumers are willing and able to pay, how much producers are willing and able to produce. In this way, price acts as a signal telling the producers what to produce and how much of the good to produce. Thus it determines the allocation of resources among various goods.
For whom to produce
The price mechanism shows for whom to produce these resources. This can be answered by looking at the willingness and ability to pay of consumers and then the output can only be distributed to these people. This in turn depends on the purchasing power and the value that people place on the good.
How to produce?
Prices of resources also address the question of how to produce. An economy can choose to produce using various factors of production like labor or capital. The price of resources guides firms’ production methods and firms choose resources that are cheap. The allocation of resources among the competing uses is based on the prices of resources.
CONCLUSION- Thus pricing mechanism answers all these questions. The resources are allocated based on demand and supply in which prices play an important function as it allocates the resources in the production of goods and services.